In addition, I have made some changes to the watch list. I have simplified the valuation methodology.

The valuation is now the sum of the current earnings yield and a simple projection of the expected growth in earnings. The current yield is based on the consensus estimate for the current year’s earnings (EPS estimate for the current year / current price).

The expected future growth rate equals 60% of the growth in EPS over the past ten years. The use of 60% is an attempt to be conservative, particularly given the challenges to the U.S. and global economies.

If a valuation sparks your interest and the company is within your circle of competence, you should research whether the factors that produced the growth over the past ten years are still in place and if the company’s position is weakening or strengthening. Where ten years of EPS data was not available, I tried to select a reasonable proxy and note it in the Comments column.

I have added valuations for stocks that are within 5% of their 52-week low or have an earnings yield that is greater than 8%.

In addition, I have added the consensus estimate for 2011 EPS to give some context to the EPS projection. I have also added the five-year average P/E to give additional context.

I stress that this watch list should only serve as a dashboard to keep you focused on areas of opportunity. These valuations are overly simplistic and should only serve as a catalyst for your own deeper analysis. I suggest calculating the earnings yield using normalized “Owner Earnings” as the numerator and also looking at the ratio of EBIT to Enterprise Value.

(The following was previously posted but provides important background information on my watch list.)

You will notice that the majority of the stocks on the watch list are categorized as a “Good Business”. That is intentional as the fourth tenet of my investing blueprint is Buy Good Businesses. I want to have an active dashboard where I can easily track all these good businesses and zero in on the ones that Mr. Market is making available at a cheap price. The basic screen for Good Businesses was inspired by Buffett in his 1987 letter to shareholders.

Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.

The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15% [emphasis added]. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.

To be categorized as a “Good Business”, I am looking for businesses that pass these Fortune tests. Given the severity of the recession, I might include a company that is close but not quite there. As you can see from the study, not many companies pass these stringent tests. If you are fishing in this pond, at least from a quantitative standpoint, you have eliminated many sub-par companies. Note that 24 out of 25 of the stocks that passed the Fortune screen outperformed the S&P over the decade preceding the study.

This approach for the watch list was also inspired by Mason Hawkins who said at a 2005 lecture at the Ben Graham Centre for Value Investing at the University of Western Ontario that he and his team revalue the top 200 businesses in the world every week to see if they are available for less than 60% of value.

By way of review, the other categories are as follows. The categories may be added to or evolve over time.

Book Value Aristocrat – exceptional book value growth over the past decade

Strong Moat – evident durable competitive advantage

Guru Purchase – recent purchase by a notable investor

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

Question: How did you come up with the five-year average P/E? Did you add up the EPS for the last 5 year years to come up with average EPS and then divide current price by that number? Or do you use some service that provides that information?

I always wonder how sites like Morningstar provide average P/E for a year. Do they take the average price for the entire year and divide that by EPS for that year? Or they average the P/E daily for the year?

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures.
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